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The Impact of Interest Rates on Capitalization Rates is Smaller Than You Think

Posted on December 1st, 2015

Interest rate versus capitalization rate

It’s only logical that capitalization rates, or cap rates, and interest rates are correlated. In a very simple term, when interest rates rise, cap rates should rise in a corresponding manner.

Yet, solely focusing on how interest rates may prompt cap rate changes may be dangerous, since multiple factors play an important role on cap rates. Taking a look at recent capital rates and 10-year treasury rates, there is a weak correlation between the two data curves. However, are interest rates the only influencing factor, or is there something else in play?

Interest-Rate-vs-Cap-Rate-Graph

The first variable is credit availability. In the period from October 1998 to May 2000, U.S. Treasury rates increased by 191 points while the stock of U.S. commercial real estate mortgages rose by over $450 billion. This resulted in the decline of cap rates over the same period and one year forward. Conversely, from December 1989 to October 1990, U.S. Treasury rates increased by 88 points while stock dropped by over $50 billion. In this scenario, the cap rates rose in that period and one year forward.

The second key variable is simple supply-demand mechanics. Between 2004 and 2008, construction financing grew approximately 18 percent as housing and commercial projects skyrocketed in growth, however only 20 percent of the space was taken during that period. Resultantly, cap rate decreased due to the drop in demand, which caused real estate prices to drop.

Inflation is another crucial variable in cap rates. If an increase in interest rates stems from an increase in inflation, then real estate values may not necessarily fall respectively. Historically, inflation has no profound effect on cap rates. When inflation hits a nation, bond rates in other nations change accordingly and may act as a buffer for the changes in real estate values. Therefore, the effects of inflation may minimize the values of real estate in a fast growing environment.

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Equal-Housing-LenderTriumph Savings Bank, a division of TBK Bank, SSB, offers flexible commercial real estate financing options. Our deep market expertise and CRE experience allows us to execute your loan quickly and efficiently. For more information, visit our website.